Saturday, November 28, 2009

DUBAI in default we trust

You know about Dubai's economic crisis. But do you know the background to - and fallout from - the crisis?

A Brief History

Who did Dubai’s emir, Mohammed bin Rashid Al Maktoum, think he was kidding? He launched one of the biggest construction booms in history, erecting the Burj Dubai, which at 161 stories is the world’s tallest building. He built artificial islands in the Persian Gulf with lofty names like “The World” that are so big they are visible from space. He bought the legendary Queen Elizabeth II, a ship that holds many fond memories of transatlantic crossings for me, to convert into a floating hotel at unimaginable expense. The spending didn’t stop there. His spending binge went global, taking a partnership role in the Las Vegas City Center, which became the worst commercial real estate project since the Tower of Babel. The problem is that all of these acquisitions were done on credit, with only a fig leaf of equity, and the wind is now blowing with hurricane force. Dubai property values have slid 50% in a year, and the plunge shows no sign of abating. No surprise then that development arm Dubai World has defaulted on $59 billion in debt. The spendthrift emir spent way too much time on horse racing and not enough on research. Sure, turning Dubai into the next Hong Kong was a laudable goal, but did anyone think this through? While the former crown colony is backed by the sweating masses of China, tiny Emirate is surrounded on two sides by 2,000 miles of sand and on the other two by the not so friendly maritime neighbors of Iran and Iraq. Oil, you may ask? My Caesar salad has more oil than Dubai. Haven’t they heard of peak oil? I always thought Dubai would revert to a ghost town once the neighborhood ran out of Texas tea. Now that Dubai’s debt has been correctly marked down to junk the big question is who else this hubris gone wild is going to take down. The shareholders of the UK’s Standard Chartered Bank and HKSB, the lead lenders, are going to take a body blow, and a rash of hickies will spread among the many syndicate members. Greece and Ireland could be next, as the premiums for their credit default swaps have skyrocketed. Things could get ugly in Dubai when the country’s 360,000 migrant Indian workers find out they aren’t going to get paid. How do you say “domino theory” in Arabic?

Historically, Dubai had an oil-based economy....?

But because Dubai's oil reserves were declining, the government - led by Sheikh Muhammed Al Maktoum - decided to diversify into other areas, especially tourism and commerce. See this and this.

That's why Dubai built the world's only 7 star hotel, a series of luxury islands, and the world's largest tower.

But the global property bubble is bursting.

As I wrote last December:

Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.

And the bubble in commercial real estate is also bursting world-wide. See this.

But Dubai got hit the hardest.

As Bloomberg notes:

Dubai suffered the world’s steepest property slump in the global recession, with home prices dropping 50 percent from their 2008 peak, according to Deutsche Bank AG.

As the CBC notes, things went South quickly in Dubai:

Hundreds of billions of dollars worth of building projects were delayed or cancelled. Thousands of jobs disappeared.

Dubai, playground of the ├╝ber-extravagant, suddenly found itself facing the very real possibility that its biggest state-owned company, Dubai World, could go into bankruptcy. It warned it was having trouble making debt payments on $59 billion US — money borrowed to pay for all the excess.

Global Impact

The CBC also notes that Dubai World has holdings worldwide:

Dubai World is Dubai's main holding and investment enterprise, but its holdings range far beyond the Persian Gulf area ...

Another Dubai World holding — DP World — operates Centerm, a container terminal in Vancouver's inner harbour. DP World acquired the terminal when it bought the marine terminal assets of P&O Ports in 2006, and plans to spend $140 million to expand it.

That purchase also gave it ownership of many key U.S. ports — something that raised national security concerns in the U.S. Some American legislators didn't like the idea that U.S. ports would be controlled by Middle Eastern state-owned enterprises. DP World subsequently sold its U.S. port assets.

In Britain, another Dubai World subsidiary, Leisurecorp, bought the Turnberry Resort in Scotland in 2008 — home to the 2009 British Open — for more than 50 million pounds.

In the U.S., Dubai World's investment arm, Istithmar World, bought the luxury retailer Barneys New York in 2007 for almost $1 billion US. There were reports earlier this year it was trying to unload the retailer as the luxury market unwound and Istithmar racked up big losses from the global financial meltdown, but Dubai World's chair denied it.

In addition, Bloomberg notes that India might be effected by Dubai's economic problems:

About 4.5 million Indians live and work in the Gulf region and remit more than $10 billion annually, according to government data. The turmoil may affect remittances, said Thomas Issac, finance minister of the southern state of Kerala, which accounted for about a quarter India’s migrant labor in 2005...

Remittances from the Middle East account for about 25 percent of Kerala’s economy, Issac said
The Royal Bank of Scotland is Dubai's biggest creditor, with $2.3 billion, or 17 percent, of Dubai World loans since January 2007. HSBC, Europe’s biggest bank, has the “largest absolute exposure” in the U.A.E. with $17 billion of loans in 2008

Yves Smith notes that Dubai's default caught creditors by surprise:

I got a message from someone who was on the conference call [with Dubai government officials]... Some European banks may be on the wrong side of this trade. As readers may know, EuroBanks went into the crisis with even lower capital levels than their US counterparts, and have taken fewer writedowns of their dodgy exposures:

The standstill announcement…was a massive surprise. One could sense the panic in those asking questions….this could be the turning point in spreads and could be viewed similar to the Russian debt crisis in 1998 or the Bear situation in 2007…based on companies and the accents of the people asking questions, it is obvious European institutions will be hit hard…Dubai made this announcement at the beginning of a four day holiday, so there will be little news until next week…There is another wave of pain out there. This information does not seem to be making its way to other markets. It will.

Zero Hedge has a good roundup of statistics regarding the biggest creditors of the United Arab Emirates, of which Dubai is a part:


Of United Arab Emirates (By Origin via Credit Suisse citing Bank for International Settlements):

United Kingdom: $50.2 billion
France: $11.3 billion
Germany: $10.6 billion
United States: $10.6 billion
Japan: $ 9.0 billion
Switzerland: $ 4.6 billion
Netherlands: $ 4.5 billion

Of United Arab Emirates (By Entity via Credit Suisse, citing Emirates Bank Association):

HSBC Bank Middle East Limited: $17.0 billion
Standard Chartered Bank: $ 7.8 billion
Barlays Bank Plc: $ 3.6 billion
ABN-Amro (RBS): $ 2.1 billion
Arab Bank Plc: $ 2.1 billion
Citibank: $ 1.9 billion
Bank of Baroda: $ 1.8 billion
Bank Saderat Iran: $ 1.7 billion
BNP Parabas: $ 1.7 billion
Lloyds: $ 1.6 billion

The Associated Press has additional details.

Bloomberg notes that Dubai's default might increase risk aversion of investors to emerging markets:

“We’re bound to see a rise in risk aversion,” Arnab Das, the London-based head of market research and strategy at Roubini Global Economics said in an interview. “The Dubai situation signifies that although the major central banks around the world have stabilized the financial system, they can’t make all the excesses simply disappear.”

India’s stocks, currency and bonds fell on concern investors may shy away from riskier emerging market assets over losses stemming from the turmoil in Dubai. India’s benchmark stock index dropped 1.3 percent yesterday, while the rupee lost 0.5 percent.

Zero hedge also notes:

  • UBS speculates that (among other possibilities) $80-90 billion (which is already over 100% of GDP) may be a low figure for Dubai's debt and that significant "off-balance sheet" amounts might explain the restructuring attempt
  • The Dubai government is on holiday (Eid Al-Adha) until December 6th
  • Abu Dhabi's Sovereign Wealth Fund (generally thought to command upwards of $500 billion) may have significantly less available. (Rumors of $125 billion in 2008 losses abounded last year). Bloomberg quotes sources to the effect that Abu Dhabi SWF's AUM has been "overstated, sometimes by as much as 100 percent."

British prime minister Gordon Brown has indicated how serious the situation is:

"Clearly the restructuring announcement has caused disruption and uncertainty in world markets,” Brown’s spokeswoman Vickie Sheriff told reporters in London. Brown’s “view is that U.K. banks are well capitalized having undergone rigorous stress testing,” she said.

And the Associated Press is asking whether Dubai's default will cause another financial panic.

The numbers involved are not that great for most creditors - on the order of hundreds of millions of dollars.

But the sense of shock and loss of confidence - when many had optimistically believed that the world economy was out of the woods - could indeed be profound....
As it turned out, we didn't have to wait five years or anything of the sort. Needing a further $10 billion in funding by the end of the year, the rulers of Dubai appear to have spoken again to their cousins in Abu Dhabi, only for the previous conditions - namely Dubai's corporate jewels to be handed over to the latter - to have been mentioned again.

We will probably never find out quite what happened in these negotiations, but the upshot of receiving $5 billion for the government of Dubai last Wednesday, November 25, appears to have been an immediate announcement of a "standstill" on the debts of the conglomerate Dubai World for a period of six months.

In the total debt pile of $59 billion attributed to Dubai World, a large amount comes under the name of Nakheel, the construction company behind some of the most iconic developments in the city, such as palm-shaped reclamation off the coast and a host of reclaimed islands in the shape of a map of the world.

The real trouble with the announcement though is that Nakheel has an Islamic bond (sukuk) due in the middle of December to the tune of $4 billion or so. This is almost sure to default because time is too short for investors to get together and agree to a standstill. Also, there is no specific clause such as "standstill" in the debt world, just an agreement to restructure.

At the weekend, the UAE's central bank said it stood behind the country's banks, easing some concern about a possible default by Dubai World. The Abu Dhabi-based central bank of the UAE said lenders would be able to borrow using a special facility tied to their current accounts, Bloomberg reported.

TBTF and real estate
Even so, with the events in Dubai, one of the central tenets of the so-called recovery from the global financial crisis was broken. This relates to the concept of "too big to fail", implying that governments and central banks will always protect systemically important entities.

For the tiny city-state of Dubai, it would be no exaggeration to suggest that Dubai World was for all intents and purposes "too big to fail". Being state-owned, run by the right-hand person of the ruler himself (until early last week), and in the limelight for the most eye-catching tourist/expatriate/investment properties in the world, Dubai World served as an extension of the ruler's ambitions in every direction.

Still, although the company owns some globally cash-rich businesses, such as Dubai Ports, and is famous for other businesses, such as Emirates Air, Dubai World has been held down by the weight of its over-ambitious real-estate ventures under the umbrella of Nakheel. Announcing a grand property venture is easy, finishing it on time and delivering the real estate profitably to one's customers isn't quite that.

More importantly, unlike cash-flow based lending (such as loans to a factory), lending for real estate is termed as asset-based lending; it depends much on the ability of the company to sell its properties for above cost, or to secure a running rental income in excess of borrowing costs. Unfinished properties don't let you do either, so it is clear that Nakheel was always going to be a challenge.

Real and unreal guarantees
The next question that popped up in the market's mind was that the rulers of Dubai had somehow violated their implicit guarantee on Dubai World. Unfortunately, that very notion is wrong in the world of credit (that is, debt): there is no such thing as an implicit guarantee; what really matters is if there is an explicit guarantee. In this case, there wasn't. So the rulers of Dubai may have decided to take advantage and escape the debt load. Essentially, this implies they had no expectation or belief that the property projects will be completed, much less that they would be profitably completed.

As the Financial Times reported on November 26, the following statement was issued by the ruling family of Dubai to debunk any of the stories of the Dubai World standstill being the result of a capricious action by one or more of its princes:
Our intervention in Dubai World was carefully planned and reflects its specific financial position. The government is spearheading the restructuring of this commercial operation in the full knowledge of how the markets would react. We understand the concerns of the market and the creditors in particular. However we have had to intervene because of the need to take decisive action to address its particular debt burden. Like most global cities, Dubai has experienced its share of economic and social challenges in this global downturn. No market is immune from economic issues. This is a sensible business decision. We want to ensure resources are deployed in the full knowledge that they are used to enhance the businesses of the Dubai World Group, build on the restructuring that has already been taking place and ensure long-term commercial success. Further information will be made available early next week.
As one of my friends remarked after reading the statement, "If this is them being 'carefully planned', imagine what they would be doing in the case of an impulsive action." In any event, whatever idea the rulers of Dubai professed to have about the "full knowledge of how the markets would react", it must have been from sources quite removed from reality, as Thursday's big declines in global stock markets led by Asia and Europe showed. Or perhaps they had sold some puts on the Hang Seng Index - what do I know?

While much of the European market reaction was tempered on Friday, declines in Asia suggested that fears of a fresh bout of contagion - the notion that all emerging markets would suffer from the fallout from Dubai - could be on the horizon. There are many reasons for this fear, not the least of which would be the stunning performances of such emerging markets over the past year or so; but also because of fears that many a Dubai lurks in this part of the world.

In the same week, we had Vietnam devaluing its currency and bumping up interest rates - taking up the dubious distinction of the only Asian country that needed to do so in 2009.

From a purely top level perspective, the idea is nonsensical. The total size of Dubai obligations, at $80 billion or so, represents a boil on the backside of the debt monster running amok in the developed and developing markets. For example, it represents barely 5% of the mortgage obligations of the US market alone; a paltry 10% of the sovereign wealth fund in neighboring Abu Dhabi; a smallish 3% of the foreign exchange reserves of China, and so on.

Then again, there is the normal contagion with which the likes of the International Monetary Fund and World Bank are familiar (being the root causes of the same); then there is the "contagion from extrapolation" that markets are more familiar with. This is where things actually get hairy.

Let us remove all the drama from the Dubai saga, and consider the facts:
1. High debt levels.
2. Poor performing collateral for debt.
3. Markets that expect continuing "strategic" bailouts.
4. A fractious political climate around debt discussions.
5. No real (sector-specific) growth to support future repayment.

If I read just the above and was asked to guess what exactly was the subject being discussed, a large number of options would spring up:
a. US mortgage debt.
b. Senior and subordinated debt of global banks.
c. Smaller European governments (Greece, Ireland etc).
d. Leveraged loans and high-yield bonds in the US and Europe.
e. Chinese bank lending to the property sector.

Don't be put off by the lack of specifics (there isn't the space to go into all of them); what really matters is that the rough, back-of-the-envelope calculation for the above five sectors alone is $4 trillion to $5 trillion. When considered in that light, the Dubai debacle suddenly becomes a mere portent of things to come; the thin end of the wedge as fundamentals reassert from the perilously slippery slope of systemic liquidity-driven prices.

Over the weekend, a number of more supportive headlines have sprung up in the financial press with respect to the Dubai story: that Abu Dhabi is "willing to help on a case-by-case basis"; that, as noted above, the "UAE central bank has agreed to provide emergency liquidity"; and even more fantastically, that the Gulf Cooperation Council (composed of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) will ride to the rescue of Dubai. All that may indeed come through, but, whatever happens, Pandora's Box has now been opened....

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